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investor should decide the securities to invest in while constructing a portfolio, how procedure involving the following five steps:
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is done using fundamental or technical analysis or both (both have been discussed in subsequent units). Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. It scrutinizes the issuer's income and expenses, assets and liabilities, management, and position in its industry. In other words, it focuses on the basics of the business. Technical analysis is a method used to evaluate the worth of a security by studying market statistics. Unlike fundamental analysis, technical analysis disregards an issuer's financial statements. Instead, it relies upon market performance of the scrip to ascertain investor sentiment. 3. Portfolio construction the third step identifies the specific assets in which to invest, and determines the amounts to put into each asset. Here selectivity, timing and diversification issues are addressed. Selectivity refers to security analysis and focuses on price movements of individual securities. Timing involves forecasting of price movement of stocks relative to price movements of fixed income securities (such as bonds). Diversification aims at constructing a portfolio that minimizes the investors risk. The following table summarizes how the portfolio is constructed for an active and a passive investor. This step is the periodic revision of the portfolio using the three previous steps. A portfolio might not be the optimal one forever and needs constant Modifications. 5. Portfolio performance evaluation this step involves determining periodically how the portfolio has performed over the review period (returns earned compared to targeted returns).and 364-day. They are issued for a minimum amount of $25,000 and in multiples of $25,000. T-Bill s are issued at a discount and redeemed at par.Call money: These are short-term funds transferred between financial institutions usually for no more than one day. This is a part of the money
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market where everyday surplus funds (mostly of banks) are traded. The maturity period of call loans vary from 1 to 14 days. The money that is lent for one day in call money market is also known as overnight money. In India, call money is lent mainly to even out the short-term mismatches of assets and liabilities and to meet CARR requirement of banks. Repurchase Agreements: Repurchase agreements involve sale of a security with an undertaking to buy it back at a predetermined price on a future date. When a party trades treasury securities, but decides to buy them back later (usually 314 days later) for a certain amount, it is called repo from the point of the seller of the security. The same is viewed as reverse repo from the standpoint of the buyer of the security. Thus, repo agreement is essentially a short-term collateralized loan. Negotiable Certificates of Deposit (CD): These are bank issued time deposits that specify an interest rate and maturity date, and are negotiable (saleable in a secondary market). CDs are issued at a discount. The discount rate is freely determined by the issuing bank considering the prevailing call money rates, Treasury bill rate, maturity of the CD and its relation with the customer, etc. The minimum size for the issue of CDs is $5 lakh (face value) and thereafter in multiples of $1 lakh. Commercial Paper (CAP): In order to raise short-term cash, a bank finance for working capital. Generally, companies prefer this route when the interest rate charged by banks is higher than the rate at which funds can be raised through CP. Bankers' Acceptances: These are time drafts payable to a trader of goods, with payment assured by a bank. Bankers' acceptance is a post-dated cheese, which guarantees the payment. International trade transactions are financed usually by these.
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effect on the earnings per share and rates of return offered by the industry. As a result, the ability to recognize the industry life cycle stage is a valuable asset for any investor. Generally industries evolve through three stagesthe pioneering stage, the expansion stage, and the stabilization stage. This concept of an industry life cycle applies to industries or product lines within an industry. Pioneering stage: During this stage, there is a rapid growth in demand for the company. Many companies fail at this stage as a result of strong competitive pressures while others achieve rapid growth in sales and earnings. The investors of such companies have a good chance of earning more than the expected returns. At the same time the risk of the firm failing is also high. Expansion stage: In this stage the pioneer firms that have survived continue to grow and prosper at a moderate growth rate. In this phase, firms focus on improving their products and at times lower prices. As firms have stabilized in financial performance the companies they attract investment capital. This is because investors prefer to invest in these firms with proven track record and low risk of failure. Also the dividends pay-outs are good that make it more attractive for the investor to buy stock of these firms to investors. Stabilization stage (maturity stage): This is a stage of moderate growth for firms. Sales increase, but at a slower rate. Products are standardized and less innovative while competition is stiff, and costs are stable. Such firms continue to operate without significant growth, and are usually headed for stagnation. The three-part classification of industry life cycle described above aids the investors in narrowing down their investment target. Industry structure and performance You may have read Michael Porters work on competitive strategy. Here heals about how the competitive rivalry in an industry governs its ability to sustain above-average returns. According to Porter, competition has the following five dimensions.
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Threat of new entrants: New entrants put pressure on price and profits. Therefore barriers to entry can be a key determinant of an industrys profitability. The most attractive segment has high entry barriers and low exit barriers. Although any firm should be able to enter and exit a market, each industry often presents varying levels of difficulty, commonly driven by economies. Manufacturing-based industries are more difficult to enter than many service-based industries. Barriers to entry protect profitable areas for firms and inhibit additional rivals from entering the market. Bargaining power of buyers: The bargaining power of buyers describes the impact customers have on an industry. Rivalry between existing competitors: Firms make efforts to establish a competitive advantage over their rivals. The intensity of rivalry varies within each industry. Industries that are concentrated, versus fragmented, often display the highest level of rivalry. Threat of substitute products or services: Substitute products are those that are available in other industries that meet an identical or similar need for the end user. As more substitutes become available and affordable, the demand becomes more elastic since customers have more alternatives. Substitute products may limit the ability of firms within an industry to raise prices and improve margins. Bargaining power of suppliers: An industry that produces goods requires raw materials. This leads to buyer-supplier relationships between the industry and firms that provide raw materials. Depending on where the power lies, suppliers may be able to exert an influence on the producing industry. The strength of these five factors varies across industries and can change over time. Fundamental analysts analyse the industry structure to find the strength of the five forces, which in turn determine industry profitability.
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Q4. Differences between fundamental and technical analysis. Ans. 1. Charts vs. financial statements: A technical analyst approaches a security via the charts, while a fundamental analyst studies the financial statements. Technical analysis is the study of price action and trend, while fundamental analysis focuses the companys performance in the backdrop of industry and economy conditions. By looking at the financial statements (income statement, balance sheet and cash flow statement) a fundamental analyst determines a companys value. The technical analyst sees no reason for analyzing the companys fundamentals as he believes that they are already accounted for in the stocks price. Al the information that a technical analyst desires is there in the price of the securities that can be found in the charts. 2. Time horizon: Fundamental analysts take a longer term view of the market when compared to the technical analysts. Technical analysis has a timeframe of weeks or even days whereas fundamental analysis often looks at data over a number of years. The difference in the timeframes is because of the different investing styles of fundamental and technical analysis. It can take a long time for an undervalued stock, uncovered by fundamental analysis, to reach its correct value. Fundamental analysis assumes that if the short-term market is wrong (in valuing a stock at less than its intrinsic value) the price of the stock will correct itself over a longer period. Also, the data analyzed in fundamental analysis covers long periods, at least a quarter and usually a year. In contrast the price and volume data that the technical analysts use are generated continually, all the time. 3. Trading vs. investing: The goals of technical and fundamental analysis are often different. Generally fundamental analysis is oriented to investment decisions, while technical analysis is more relevant for trading decisions. Investors buy assets that
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they believe can increase in value and yield returns over longer periods. Traders buy assets that they believe they can sell quickly at a higher price. 4. Cause vs. effect: While both approaches have the same objective of predicting the direction of prices, the fundamental analyst studies the causes of market movements, while the technical analyst studies the effect of market movements. The fundamental analyst needs to know why the prices have changed. The technical analyst, on the other hand, attempts to find where the prices can be expected to change. Although technical analysis and fundamental analysis may seem to be poles apart, many market participants have achieved success by combining both. Thus a fundamental analyst may use technical analysis to figure out the best time to enter into an undervalued security. Often this opportunity is present when the security is severely oversold. By timing entry into a security, the gains on the investment can be greatly improved. Similarly, some technical traders might look at fundamentals to add strength to a technical signal. For example, if a sell signal is obtained after technical analysis, a technical trader might look at Fundamental data before going ahead with the decision.
Q5. Explain the implications of EMH for security analysis and portfolio management. Ans. Implications for active and passive investment Proponents of EMH often advocate passive as opposed to active investment strategies. Active management is the art of stock-picking and market-timing. The policy of passive investors is to buy and hold a broad-based market index. Passive investors spend neither on market research, on frequent purchase nor on sale of shares. The efficient market debate plays an important role in the decision between active and passive investing. Active managers argue that less efficient markets provide the opportunity for
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skillful managers to outperform the market. However, it is important to realize that a majority of active managers in a given market will underperform the appropriate benchmark in the long run whether or not the markets are efficient. This is because active management is a zero-sum game in which the only way a participant can profit is for another less fortunate active participant to lose. However, when costs are added, even marginal y successful active managers may underperform the market. By and large, performance record of professionally managed funds does not support the claim that active managers can consistently beat the market. The empirical evidence is that investing in passively managed funds such as index fund has outperformed actively managed funds for the last several decades. If markets are efficient, what is the role for investment professionals? Those who accept EMH generally reason that the primary role of a portfolio manager consists of analyzing and investing appropriately based on an investor's tax considerations and risk profile. Optimal portfolios will vary according to factors such as age, tax bracket, risk aversion, and employment. The role of the portfolio manager in an efficient market is to tailor a portfolio to those needs, rather than to beat the market. 6.10.2 Implications for investors and companies EMH has a number of implications for both investors and companies. For investors: Much of the existing evidence indicates that the stock market is highly efficient, and therefore, investors have little to gain from active management strategies. Attempts to beat the market are not only useless but can reduce returns due to the costs incurred in active management (management fees, transaction costs, taxes, etc.). Investors should therefore follow a passive investment strategy, which makes no attempt to beat the market. This does not mean that there is no role for portfolio management. Returns can be optimized through diversification and asset allocation, and by minimization of investment costs and taxes. In addition, the portfolio should be geared to the time horizon and risk profile of the investor. Public information cannot be used to
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earn abnormal returns. Therefore, the implication is that fundamental analysis is a waste of time and money and as long as market efficiency is maintained, the average investor should buy and hold a suitably diversified portfolio. Investors, however, will have to make efforts to obtain timely information. Semi-strong form of market efficiency depends on the quality and quantity of publicly available information. Therefore, companies should be encouraged by investor pressure, accounting bodies, government rulings and stock market regulation to provide as much information as feasible, subject to the need for secrecy. The perception of a fair and efficient market can be improved by more constraints and deterrents placed on insider trading. For companies: EMH also has implications for companies. Companies should focus on substance, not on window-dressing accounting data: Some managers believe that they can fool shareholders through creative accounting but investors are able to see through the manipulation and interpret the real position, and consequently security prices do not rise. The timing of security issues does not have to be fine-tuned: A company need not delay a share issue thinking that its shares are currently under-priced because the market is low and hoping that the market will rise to a more normal level later. This thinking defies the logic of the EMH if the market is efficient the shares are already correctly priced and it is just as likely that the next move in prices wil be down as up.
Q6. What is Capital Asset Pricing Model (CAPM)? Write the assumptions of CAPM. Ans. Capital asset pricing means defining an appropriate risk adjusted rate of return for a given asset. Capital Asset Pricing Model (CAPM) is a model that helps in this
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exercise. Will iam Sharpe, Trey nor and Linter contributed to the development of this model. An important consequence of the modern portfolio theory as introduced by Markowitz was that the only meaningful aspect of total risk to consider for any individual asset is its contribution to the total risk of a portfolio. CAPM extended Harry Markowitzs portfolio theory to introduce the notions of systematic and unsystematic (or unique) risk. Assumptions of CAPM Al investors are assumed to follow the mean-variance approach, i.e. the riskaverse investor will ascribe to the methodology of reducing portfolio risk by combining assets with counterbalancing correlations. Assets are infinitely divisible. There is a risk-free rate at which an investor may lend or borrow. This risk-free rate is the same for all investors. Taxes and transactions costs are irrelevant. Al investors have same holding period. Information is freely and instantly available to all investors. Investors have homogeneous expectations i.e. all investors have the same expectations with respect to the inputs that are used to derive the Markowitz efficient portfolios (asset returns, variances and correlations). Markets are assumed to be perfectly competitive i.e. the number of buyers and sellers is sufficiently large, and all investors are small enough relative to the market, so that no individual investor can influence an assets price. Consequently all investors are price takers. Market price is determined by matching supply and demand. Investors are considered to be a homogeneous group. They have the same expectations, same one-period horizon, same risk-free rate and information is freely and instantly available to all investors. This is an extreme case, but it allows the focus to change from how an individual should invest to what would happen to security prices if everyone invested in a similar manner. Some of these
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assumptions of CAPM are clearly unrealistic. But relaxing many of these assumptions would have only minor influence on the model and would not change its main implications or conclusions. The primary way to judge a theory is to see how well it explains and helps predict behavior. While CAPM does not completely explain the variation in stock returns, it remains the most widely used method for calculating the cost of capital.
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